Choosing between a Traditional vs. a Roth IRA is a choice of asset location.

One type of IRA isn’t better than the other. It’s your situation that determines the account that will optimize your after-tax return.

The advice I find online on this topic, are statements like, “If your tax bracket will be higher now than in retirement, invest in a Traditional IRA.”

This can be good advice.

But to get the right answer, there’s a lot more you must know.

It’s worth mentioning, this is an important decision. Deciding between the right account today will impact the quality of your life in years to come.

This article will discuss:

The difference between a Roth vs. Traditional IRA

Knowing your marginal tax rate & why it matters

Understanding the impact of IRA required minimum distributions

The difference in Roth & Traditional IRA contribution limits

General guidelines for who should choose a Roth IRA

General guidelines for who should choose a Traditional IRA

General guidelines for investing in both a Traditional & Roth IRA

The primary difference between a Traditional vs. Roth IRA is in the taxation benefits.

Traditional IRA – Contributions are tax-deductible and taxes are deferred until withdrawn.

Roth IRA – Contributions are not deductible but withdrawals are tax-free.

But that’s just the beginning.

Here’s what else you need to know, which may impact your decision:

Age Requirements

Traditional: Must be under the age of 70 1/2 with employment income

Roth: Anyone can contribute as long as they have employment income

2019 Contribution Limits

Traditional: $6,000; $7,000, if age 50 or older

Roth: $6,000; $7,000, if age 50 or older

Income Requirements

Traditional: As long as you have employment income, you’re eligible to contribute. Tax deductibility depends on your income and participation in an employer plan.

Roth: Income limits do apply.

Qualified Withdrawals

Traditional: Contributions and earnings are taxed as ordinary income at the time of withdrawal.

Roth: You can withdraw contributions and earnings tax-free after age 59 1/2.

Non-Qualified Withdrawals

Traditional: The entire amount of your withdrawal is subject to a 10% penalty

Roth: You can withdraw contributions tax and penalty free before age 59 1/2. Earnings that withdrawn before the age 59 1/2, are charged a 10% penalty. Exceptions do apply.

Minimum required distributions (MRDs)

Traditional: Minimum required distributions starting at 70½

Roth: Withdrawals are not required during your lifetime

Section footnotes:

What is a qualified withdrawal? – If you’re over the age of 59 1/2, you may withdraw any amount from a Traditional IRA penalty-free. You can withdraw penalty free from a Roth IRA after the age of 59 1/2, as long as the account has been open 5 years. There are special exemption to avoid penalties.

When it comes to choosing the right IRA, the #1 factor is comparing your current vs. future tax rates.

Your goal is to pay taxes, at the lowest possible rate. That’s why you hear the advice:

If your tax rates today are lower than they will be at the time of withdrawal, choose a Roth IRA

If your tax rates today are higher than they will be at the time of withdrawal, choose a Traditional IRA

And this is true.

But, there’s a common mistake that’s often made.

To understand what you’re taxed today, you must know your marginal tax rate. Your marginal tax rate is the tax rate applied to the next $1 of income.

For example, say your federal tax bracket is 25%, your state tax bracket is 5% (forgetting to include state taxes is mistake # 2).

To keep things simple, you take the standard deduction and are not affected by any credits, phase-outs, etc..

In this scenario, an extra $1 of income would have a marginal tax rate of 30%.

The easiest way to understand your marginal tax rate is to use tax software. (You don’t have to buy the software unless you file)

You can add $1,000 to your income and see the impact. If you’re considering investing in a Traditional IRA, deduct $1,000 to measure impact.

It can be more complicated once you add in income phaseouts, credits, etc… But, the above will allow you to have to have a close estimate of your marginal tax rate.

Section footnotes:

You lose a lot of tax credits as you retire. You don’t want to over save in tax-deferred accounts. Not as many tax credits. You will lose child credits. Your mortgage may be paid off. Etc..

If you plan to pass on your IRA, you must factor in the marginal tax rate of the beneficiary. You want to look at your current marginal tax rate compared to the expected marginal tax rate of the beneficiary.

About The Author

R.J. Weiss is the founder and editor of The Ways To Wealth, a Certified Financial Planner™, husband and father of three. He's spent the last 10+ years writing about personal finance and has been featured in Forbes, Bloomberg, MSN Money, and other publications.

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